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How the accountants mangled capitalism

SA is not alone – it’s a global phenomenon.

We are programmed to regard accountants with reverence and unquestioning trust. They are the record keepers of the economy and arbiters of financial truth.

Double-entry bookkeeping was an astounding development. It allowed business owners to record assets and liabilities rather than simply track the movement of cash and goods. It introduced the concept of ‘capital’ to the business world centuries before Karl Marx wrote Das Kapital. With this new insight, business owners could accurately reflect profits, which in turn opened up opportunities for outside investors.

Just as astounding is the rise of the Big Four accounting firms – EY, PwC, Deloitte and KPMG – as business titans equal to or even mightier than their clients. The Big Four audit 97% of US public companies, 100% of the UK’s top companies and 80% of Japanese-listed companies. Not to mention their overwhelming representation among the JSE’s top companies. Yet trust in the accounting profession has seldom been lower.

Richard Brooks – author of Bean Counters: The Triumph of the Accountants and How They Broke Capitalism – details why this trust has slipped, and how a nicely balanced set of figures can often be a fraudster’s friend.

The major accounting firms have managed to avoid the scrutiny that their importance warrants. Perhaps, as Brooks advises, we should force them to open their financial statements to public scrutiny so we can see how they earn their money.

Before the Big Four there were the Big Five – Arthur Andersen & Co having disappeared in a puff of smoke after it cooked up false accounts for the now defunct US energy company Enron.

A mandatory 10-year audit rotation is the latest solution to this overwhelming concentration and the inevitable Stockholm syndrome that comes from having auditors sleep with the same client, year after year. Consider that KPMG counted General Electric as a 106-year-old client and PwC stepped down from the Barclays audit in 2016 after 120 years. It hardly needs pointing out that given enough time, the Big Four (if they are still around in 10 years, which is a pretty safe bet) will eventually cycle back to the clients who rotated them out of their engagements.

Accounting regulators are working overtime to keep up with the schemes being hatched to boost revenue (think Tongaat) or hide liabilities (Steinhoff). Given enough accounting scandals, and we surely have enough of those, investors will start to apply a ‘truth discount’ on all public companies’ figures.

It would be foolhardy to count on the regulators to bring sanity to the profession. As Brooks points out, the accounting standard-setters are swimming in alumni from the Big Four, ensuring that the rules are crafted to suit the major accounting firms and their clients. If you are a major company, you cannot stray very far from one of the Big Four, despite the efforts of the Independent Regulatory Board for Auditors (Irba) to transform the sector and introduce co-audits for black firms.

Every crisis is a revenue opportunity

What is astonishing is the growth in revenue of the Big Four firms through good times and bad. Brooks demonstrates that their revenue growth barely paused for breath during the 2008/9 financial collapse. Every crisis, or indeed change, is a revenue opportunity for these firms: Y2K, climate change, cyber security, corporate governance, business restructuring and integrated reporting. You name it, they have a solution for you. The result is sports-star-level incomes for men and women employing no special talent and taking no personal or entrepreneurial risk.

Worldwide, these firms make just 39% of their income from audit. They have become consulting firms with auditing sidelines. Though these firms will swear that auditing and getting the numbers right is the sacrosanct heart of their business, the evidence suggests otherwise. With so many inadequate audits on their own ledgers, one might expect a dip in their earnings. You would be wrong. Poor performance is not a matter of life and death when there are so few competitors from which to choose.

Their own key performance indicators (KPIs) emphasise revenue growth, profit margin and staff satisfaction, rather than exposing false accounting, fraud, tax evasion and the systemic risk these pose to the economies they operate in.

The demise of sound accounting became a critical cause of the early-21st-century financial crisis, says Bean Counters. The tendency is to blame reckless banking practices for the last financial collapse, but far less attention is given to the accountants who signed off on dud loan books.

Books sanctified by ‘magic’

Vincent Daniel was a disaffected former Arthur Andersen accountant employed by Steve Eisman, depicted in the film The Big Short. In just a few months, Daniel came to the conclusion that the subprime mortgage loans being dished out by the major banks suffered exceptionally high delinquency rates. He saw what the major accounting firms had apparently missed or ignored. Eisman and several other short sellers made fortunes predicting the subprime crisis – yet the banks’ books, sanctified by the magic of mark-to-market accounting, pretended nothing was amiss. Millions of people were impoverished by the willful negligence of the accounting firms.

That’s what happens when accountants go rogue.

Undeterred, the Big Four raced off to India and China to capitalise on the record-breaking growth in these zones. The Bean Counters details how the same lapses in oversight started to appear in these new markets. Deloitte was forced to resign from two important clients after signing off on vastly inflated profit figures. Again, it was the short-sellers who highlighted these anomalies. PwC was fined by US authorities for a deficient audit at Indian IT company Satyam. In one country after another, each of the Big Four has been sanctioned, fined and worse for turning a blind eye to fraud, corruption or fake accounting.

Operating with impunity

Despite the economic wreckage caused by accounting firms, they operate with relative impunity. “Even before Enron, the big firms had persuaded governments that litigation against them was an existential threat,” writes Brooks. “They should therefore be allowed to operate with limited liability, suable only to the extent of the modest funds their partners invested in their firms rather than all their personal wealth.”

Perhaps even more troubling is the fact that governments turn to these accountants for advice on tax, finance, trade and other issues.

Complexity is always a money-making opportunity for these accountants, and the rules they craft in the ‘national interest’ are often serving another master entirely.

Are these the right people to be guiding national policy?

Blatant corruption in accounting is the exception. The real problem is the profession’s “unique privileges and conflicts that distil ordinary human foibles into less criminal but equally corrosive practice,” says Brooks.

For years there has been talk of breaking up the Big Four, and detaching their audit operations from their consulting arms. It happened after Enron and it’s happening again now. The accounting firms concede the need for reform, but never to the point of threatening their fee-earning capacities.

One possible solution is to have an independent body appoint auditors, rather than allowing clients to make their own choices. After all, auditors are there to perform a public oversight function that goes far beyond the interests of management and shareholders.

Audit rotation will certainly help. But the only real long-term solution is to reintroduce a questioning, objective and sceptical mindset to the business of accounting and auditing.

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Auditors always tell me about the many areas of judgment in response to me questioning why a valuation / revenue / expense number is not reflective of economic value. It seems like their “judgment” is mostly used to help management teams achieve bonus targets rather than to achieve the right outcomes (let income statements convey economic value generated / performance on a consistent accountable basis and balance sheets reflect realizable shareholder value). “Judgment” without scruples and consequences to them.

“The numbers in any accounting report mean nothing, per se, as to economic value. They are guidelines to tell you something about how to get at economic value. … To figure out that answer, you have to understand something about business.” – Warren Buffet

“In the financial statements, there are only 2 figures you can trust. Those are the page numbers and the dividend per share because you can verify the latter in your bank account.” – Warren Buffet

Bravo Sensei. To my mind all that counts is cash flow, everything else is meaningless. I’ll leave that to the smarter okes than me … like Marcus Jooste

Accounting and IFRS has gotten too clever. I could take the same set of transactions and present two unrecognizably different set of AFS, both able to be signed off.

But I am getting tired of the analysts blaming the auditors after each scandal. Auditors are not there to detect fraud, shareholders cannot afford that level of audit fee. The analysts with retail experience and a brain cel avoided Steinhoff, Investors that can interpret cashflow avoided 2007.

Everything is always somebody else’s fault I suppose

IFRS has decimated the reality of business. It is a valuation statement that is subject to so many assumptions and interpretations that it can be crafted to what ever the preparer wants it to be.

IFRS was designed to enable analysts to compare a hospital to a coal mine. Analysts do not use IFRS much for their decisions. This is where the accountants have destroyed accounting.

The auditors spend an inordinate amount of time validating Athe IFRS adjustments and arguing with the FD to agree a final position. Then they forget about auditing the business. Another casualty of insane IFRS are the auditors!!!!

Have you ever looked at IFRS?

IFRS just tells you to categorize certain amounts as something.
For example a building worth R1 million.
IFRS will tell you that if it is a office building than its PPE, if it is used for rental income than its Investment property.

Now its up to the FD to say “valuation of this year depreciation on this building is” R xxx amount. The auditors will be like. Yes/No, it seems fair or not. Because a FD can be like we are going to have 1% depreciation this year to boost profits. But auditors will argue, no this depreciation is not enough compared to other buildings in the area. etc. etc.

One of the issues at steinhoff was valuation. They overvalued the business they were buying. IFRS wasn’t they issue, its the valuation.

An asset is an asset, a liability a liabilty and equity an equity. Can’t screw that up. Its the R amounts that is the issue at the end of the day.

Its natural to want to blame someone or something, but this is like blaming the bullet for killing someone. Baby out with the bathwater… The Malaysian Airlines pilot who they say committed suicide took all those people with him. All planes (and pilots) aren’t evil because of that, are they? And if they are, how will we cross the Atlantic or Indian oceans to visit all those good people who were lucky/brave enough to leave SA? There will always be some bad people who will use the tools ordinary people rely on for their day to day existence to achieve their own nefarious ends. Tools which work well enough when they are in the hands of ordinary (read: honest, law abiding, community and family orientated) people.

“The result is sports-star-level incomes for men and women employing no special talent and taking no personal or entrepreneurial risk”.

Same could be said for pretty much the entire financial investment and advisory industry.

Perfectly said,
their service can/should be automated in the background. They have no value creating ability.

but the illusion that when working with money you are skilled and responsible for creating the money!

And for sports stars, tv personalities, politicians and lawyers…

Yes big 4 dominance can be problematic. But.
For auditors to find fraud and theft its nearly impossible unless:
-You pay 10-100x more audit fee, because scope of work is going to be exponentially bigger. You are going to need to get directors/executives/employees personal bank details, do life style audits, PI and investigative work etc.etc.

Look at how long steinhoff investigation is taking. Take a look at any other investigations done due to audit failure and it takes years to produce any report.

No-one is going pay R100 million plus fees every year for this.

This kinda articles are written by people who don’t know what “Audit” is.
They have this imaginery thought in their heads where audits are like Sherlock Holmes digging through every clues to find fraud.
No, audit only considers Material issues. A company can have hundreds of thousands to millions of transactions. Out of that, about a percentage of it is material and a sample of random transactions are taken for testing. If you want to test everything it can take years. It’s impossible unless you pay 10-100x more audit fees and have hundreds of auditors running around your company year round badgering you and disturbing your business for audit work.

Agree.

However, one should be careful to shift blame completely. Maybe then the use of the entire audit profession could be question.

Maybe future technologies can over a solution surrounding the millions of transactions.

@Henry Peters – exactly. Although I don’t think auditors are free from blame, the following paragraph shows exactly how deluded some people are regarding what an audit is:

“Their own key performance indicators (KPIs) emphasise revenue growth, profit margin and staff satisfaction, rather than exposing false accounting, fraud, tax evasion and the systemic risk these pose to the economies they operate in.”

Giving an audit firm a KPI that is based on the number of fraud cases found is like giving a policeman a KPI based on the number of people they shoot.

KPI is the least of the issues with audit failures.

I can see the article was written by someone who has no idea what the audit process pertains.

If you want to know some of the real issues, read some of the jokes and comments on reddit/r/accounting
Its real CPA & CAs commenting there. Will give you some insight into the industry…

Also some of the main reasons is:
– Audit deadline. Due to reporting deadlines, budgets and such, most audits are under enormous time pressure.
– Audits are mostly (about 60% +) done by trainees. Nearly all ground work is done by trainees. Young adults who just came out of varsity without any experience. SAICA articles are about 3 years. You have these trainees 1-3 years of experience doing most of the audits.

Now you have these trainees doing most of the audit with time pressure. How do you expect them to find fraud against CFO/FD who are CAs with years of buisness and audit experience??? All you can do is do extra work and come up with strategies to mitigate risk.

We have thousands of murder cases in SA every year and we see little convictions. Does it mean we don’t need police at all?

There was a article last year which showed that Steinhoff paid R650 million over 4 months to investigate the irregularities. Audit fees were a fraction of this. The scope of work done is vastly different.

So if we want Financials that are free from fraud we need Forensic investigations not audit.

So if they are unable to state there was no fraud, why do we need auditors at all? Why not just trust the FD/mgmt as shareholders and sue them/jail if there was an issue? What purpose do auditors now fulfill if there is no difference between corporate success or failure?

The accountant is there to count the money and present the related information to the manager/owner to be able to run a profitable business.
Business decisions are made by the manager (who may or may not be an accountant, but had better understand finance else the accountant will be able to assert undue influence)
The auditor can only do spot checks to monitor the work of the accountant.
(This also applies to a minister of finance who functions as an accountant. Spend can only be controlled by the spender, under strict supervision.)

What happens when Accountants (KPMG) goes rogue?

The late Barry Sergeant describe KPMG’s role in ‘’Investecgate and Kebblegate’’ in detail in his last book, The Kebble Collusion: 10 Fateful Days in an R26 Billion Fraud.

A full chapter of this book was ‘’set aside’’ for the KPMG’s shenanigans! The forensic auditors report from JLMC to this day remains unchallenged.

JLMC investigation had revealed that R&E was the victim of substantial fraud and theft, perpetrated largely by JCI, its subsidiaries, and associated companies.

R&E had also instituted claims against Investec Bank (UK) and T-Sec, at the time!

Methinks Peter Henry had his ‘’knickers in a knot’’ in the latest ‘’Update to Shareholders on CIPC Application – 1 July 2019. In paragraph 19 he claims he ‘’had no involvement’’ in the affairs of JCI – that is a bit rich coming from one of Kebble’s lackeys – from his Societe Generale, Johannesburg Branch to TSec days! If anybody should have made alarm – actually massive waves about Kebbles’s shenanigans, I had to be him. Barry covered Peter Henry’s role in a plethora of monthly financial magazines during the last 10-15 years as well. Every single Noseweek, Financial mail, the etc article went ”unchallenged” by him!

How is it at all possible for an auditor (KPMG) to walk away from a client (JCI), after it received more than R 100 million in fees over years?

Further to my view: Amazingly, (and Peter Henry should be well aware of this), Investec in 2005 took control of the boards of JCI, Randgold and Western Areas – and thereafter forced Randgold to enter into mediation with JCI and thereby basically settling all the frauds.
Methinks the Kebble frauds were ‘’ minute’’ (stolen money) and the proceeds of the thefts was used in the Investec joint venture gold derivative book where 5, 46 million Randgold Resources shares that JCI nicked, was paid to Investec The eventual primary beneficiaries of this approximate ZAR 7 billion was used to settle loans due and the so-called Investec Loan Agreement by JCI to Investec.
Methinks Western Areas shareholders and the Gold derivative Banks couldn’t believe their luck when they got paid millions from the stolen loot – and Brett Kebble to this day must bear the brunt of the blame, although he received peanuts!
Peter Henry (as CEO of Tsec) should have been well aware that Tsec was laundering the proceeds of the money stolen from Randgold and then paying it to third parties!
He should also (as CEO of JCI and Randgold) be aware that KPMG skipped audits for JCI from 2005 to 2007 and Randgold from 2004 to 2006 (and alas, nobody knows what goes on behind closed doors). But, KPMG signed off on non-compliant financials for JCI from the 2008 to 2016 accounts.
Hence KPMG now advised JCI that their statements are not complying with of IFRS requirements and that they are declining to accept the audit engagement for the periods 2013 to 2018.

Auditing is inherently a conflict of interest.

Auditors are paid by the firms whose books they look after to keep those firms and their shareholders happy (at least in terms of the figures conjured up and published)

If auditors were instead paid by government or regulators to be the police of businesses as they are supposed to be, we would see a different picture.

But then where would they get their business lunches, fancy cars and international family trips from?

These days , the world is only looking short term – including directors, auditors AND the investor. No one seems to want to know facts, they want the positive spin that drives up their investment so they can move on to the next thing. If the pace of life slowed down and we took the time to care – everyone would be a lot more careful, including directors, auditors AND the investor.

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